Question

SkyBlue Co. is a Chicago-based company that provides self-storage rental service. The management team of SkyBlue has been discussing whether to build a new storage facility on the west side of the city. At the management meeting, Miller Brown, the chief financial officer, presented the following information: “Six years ago, we acquired the necessary land at a cost of $475,000, and spent $90,000 to demolish worthless buildings on the land. Since then, we have rented the land to Chicago Convention Center, which is located nearby, as a temporary parking lot. We have received an 4 annual revenue of $6,000 on average for this use of the land. According to the forecasts made by my team, the proposed storage facility can provide 270 storage units in total, of which 50 are large-size, 120 are mid-size, and 100 are small-size). The storage units can be rented on a monthly or daily basis. The monthly rate for large-size, mid-size, and small-size storage units is expected to be set at $75, $50, and $40, respectively. And the daily rate for large-size, mid-size, and small-size storage units is expected to be set at $4, $2.4, and $2, respectively. The number of large-size, mid-size, and small-size units rented at the monthly rate is estimated to be 30, 70, and 60, respectively. The average number of clients paying the daily rate would be 10, 30, and 25, respectively (for each of the 30 days per month, assuming that the storage facility would operate 30 days per month). There would be one-time construction cost of the storage facility, $32,000. Fixed costs to operate the storage facility per month would be $5,000. The monthly variable cost of servicing each monthly client would be $8. The estimated cost per daily client would be $1.6.”

Required: Given the information provided, would you recommend building this storage facility? Explain why (please be sure to discuss costs that relevant or irrelevant to this decision and why there are relevant or irrelevant, show your numerical analysis, and limit your answer to 500 words or less).

Answer 1

Initial cost 6 years ago (A)	$565,000
4 annual revenues of $6,000 each received till now (B)	$24,000
Balance uncovered cost at Year 0 (A-B)	$541,000
One-time construction cost for storage units at Year 0	$32,000
Total Cost at Year 0	$573,000

	L	M	S	Total
No. of units available	50	120	100
Estimated revenues per month:
Expected units rented on monthly basis	30	70	60	160
Monthly rent rate	$75	$50	$40
Estimated monthly revenues	$2,250	$3,500	$2,400	$8,150
Expected units rented on daily basis	10	30	25	65
Daily rent rate	$4	$2	$2
Estimated monthly revenues on daily rent basis	$1,200	$2,160	$1,500	$4,860
Expected total monthly revenue				$13,010

Estimated costs per month:	Rate	Amount per month
Fixed costs per month		$5,000
Variable cost per month per monthly client	$8	$1,280
Variable cost per month per daily client	$2	$104
Expected total costs per month		$6,384

Estimated inflows per month = Estimated revenues per month - Estimated expenses per month

= $ 13,010 - $6,384 = $6,626

Estimated inflows per year = $6,626 * 12 = $79,512

So, here above, we calculate the revenues and costs associated with the project, with an analysis whether the net is an inflow or outflow. Based on estimated units that would be rented and prices for each, an estimate of the monthly revenues is provided. Similarly, total of estimated costs per month is calculated. We see that expected revenues are more than costs. So, that is first sign that the project can be considered.

Also, if we see that the annual revenues from storage units construction is estimated at $79,512, while the revenues received on land were a meagre $6,000 annually, which is again a positive sign to consider the project.

Further, if we see the initial cost on the land 6 years ago and the receipts till date, we see that as of now, $541,000 is the previous cost which have not been covered as yet (Note: we have not applied discounting rate. Applying appropriate discount factor gives a more fair value).

Adding to that, the one-time construction cost for storage units of $32,000, the total cost at Year 0 = $573,000.

We can apply various Capital Budgeting techniques such as Payback Period, Net Present Value of project, Accounting Rate of Return on project,etc. by applying appropriate discount factors (required rate of return) to check the feasibility of the project.

For example, calculating the Payback period = $573,000 (Cost at Year 0) / $79,512 (inflows each year), we see the project will return initial cost in 7.2 years.

Further, we can apply appropriate rate of return to get net present value of project and compare it with costs at present, to see if the NPV is a + no. (go-ahead signal) or a - ve no. (no-go signal).

For example, applying a 5% RR and $79512 annual inflows expected for the next 10 years, gives us Present value of project as $613,970.50, while the costs are $573,000. So, NPV of the project would be $613,970.50 - $573,000 = $40,970.59, which is positive net present value of project.